The most important formula in investing? No, its not CAPM (capital asset pricing model), the formula that led a revolution in the way the financial markets price risk and reward. Instead, I believe it's the Kelly formula for betting.
Oh, CAPM, my CAPM!
The formula for CAPM is expected return = risk-free rate plus beta times the market risk premium. The expected return is what you expect a stock to return, the risk-free rate is government bond yields, and the market risk premium is often measured as the expected return for the S&P 500 minus the risk-free rate. Beta, the measurement of risk, is a stock's volatility relative to an index such as the S&P 500.
Although beta is a decent measurement of a stock's short-term investment risk, a better measure is a company's long-term business risk and margin of safety. For example, suppose you're standing under a swinging wrecking ball attached to a stationary crane. You could measure risk by measuring the distance between the wrecking ball and your head. However, because the wrecking ball is swinging back and forth, this measurement would be extremely volatile, and the "beta" would be very high.
However, if you knew that the length of the chain to the edge of the wrecking ball was 10 feet, you'd know that as long as you stood 11 feet away that the ball couldn't hurt you as long as it was on the chain. Instead, your focus would be on how strong the chain is and how much distance, or margin of safety, you would need to feel comfortable with a huge wrecking ball swinging over your head. Instead of focusing on a stock's short-term volatility, value investors should focus on the strength of the company's business and margin of safety.
The Kelly method
So instead of CAPM, I believe investors should use the much more attractive-sounding Kelly method. Albert Einstein said all things should be as simple as possible and no simpler. The Kelly method simply states that an investor should invest according to the following formula: edge divided by odds. Although neither edge nor odds can be precisely calculated in the stock market, the process of estimating edge and odds forces investors to ask themselves some key questions.
Edge: What are my chances of winning, and why?
If we're both bidding on a painting at a yard sale, and I know the painting's a Van Gogh and you think it's just a pretty picture that would look good in your bathroom, then I have a profitable informational advantage. Conversely, if we both know it's a Van Gogh, then neither of us has an edge.
A couple of months ago, bankruptcy fears plagued Lear's
This, I believed, was my informational advantage, and the stock has since gained roughly 70%. I freely admit the idea was not my own, and I was probably just lucky, but the point is that investors should only invest if they can formulate an argument for why they have an informational edge.
Odds: What do I get if I win?
A stock's payoff is usually inversely proportional to its price. The key here is to think like an owner, because stocks represent fractional ownership in the underlying businesses. Would you rather pay $1 billion to own all of the Coca-Cola
So, we're left with a simple formula: edge/odds, which is the percentage of your portfolio the Kelly formula believes you should put into a given security. Although edge and odds cannot be precisely numerically quantified and must be subjectively estimated, the true value of the formula is the discipline it imposes on the investment process. After all, the formula dictates that you risk your capital only when you have an informational advantage and the payoffs are high. This is only a cursory glance at this truly important method. I believe readers would be extremely well-served to read William Poundstone's Fortune's Formula. The book provides an informational edge, and it only costs $18 on Amazon.com, so (under the Kelly method) I would advise a purchase.
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Fool contributor Emil Lee is an analyst and a disciple of value investing. He has a long position in Lear and appreciates your comments, concerns, and complaints. The Motley Fool has a disclosure policy.